Are Troubled Banks and Fintech a Perfect Fit?

Fintech companies seeking a new bank charter in the United States have generally found the proposition to be a nonstarter. But could casting their eye toward Main Street become a viable solution to getting in the U.S. banking system?

Although fintech might revel in its outsider status, there are real benefits to being a bank and observers say as the sector matures, expect more fintech companies to seek charters. For lenders, deposits insured by the Federal Deposit Insurance Corp., are one of the cheapest funding sources around. The core banking business could provide them with a revenue stream. And having a charter could eliminate the middleman and the risk associated that, since many rely on bank partners to execute their business.

"If interest rates rise, I can see a scenario where these companies turn around and find that they need a bank charter to fund the growth of their operations," said J. Brennan Ryan, an Atlanta-based attorney with Nelson, Mullins, Riley & Scarborough. "That's the whole reason to have a bank: to have customer deposits and make loans and make money off the spread. I would not be surprised if in the next year or two if we saw more fintech-type companies applying for a bank charter."

Much of the conversation around fintechs becoming banks centers on getting de novo charters from regulators. That's a tough play — besides the complexities of fintech, de novo activity overall is rocky. There have been few since the economic downturn of 2008. Even regulators have been increasingly optimistic about de novos, observers often say that the business case for starting a new bank is not there. But with 183 banks still on the Federal Deposit Insurance Corp.'s problem list and scores of other small banks grappling with succession issues, could fintech's future be in buying relics?

Maybe, observers say. But don't expect it to be an easier path than going the de novo route. The problem ones still have troubled loans. The legacy technology is likely not suited for a slick digital platform. They'd need capital and would also likely need seasoned bankers to help them run it and win over the regulators.

Nonetheless, it is a strategy that banking attorneys say is occasionally discussed. And it is one that fintech companies determined to be a bank should consider.

"If you want to charter a new bank, expect 15 months of your life devoted to getting it," said Thomas Vartanian, a partner at Dechert. "My first choice when advising clients is to buy something. If it has some problems, the regulators likely want it acquired. That's a better situation than you begging them for a new charter."

Unlike Europe, where regulators in various countries have issued charters to digital-only startup "challenger banks," U.S. regulators have taken a more cautious approach. There are some signs that might be changing, albeit slowly. The Office of the Comptroller of the Currency said on May 9 that it was contemplating a "limited-purpose" charter designed for fintech companies. However, no decision has yet to be made and the agency has thus far offered no details about what a limited-purpose charter might look like. The OCC didn't return calls for comment. The FDIC declined to comment.

That reticence from regulators has generally led fintech companies to seek a bank partnership to do business in the U.S. That's the path taken by Fidor Bank, the highly popular German digital bank formed in 2007, which said in March it would not seek a U.S. bank charter — as it had initially mulled and successfully did in its expansion to the U.K. — and instead would seek a bank partnership.

Fidor took that route not only because it was an easier path to doing business in the U.S., but also so it could begin operating here more quickly, its chief executive Matthias Kroner said in an email.

However, one of the clear advantages of getting a charter, regardless if it is new or an acquired one, is the ability to eliminate partnerships. Currently, much of fintech relies on banks to operate. For instance, many marketplace lenders work with a small number of banks to initially make the loans. However, there is risk in that model. A fintech company's business is reliant on a bank and its operations could be challenged should something happen to the bank. (Indeed, PayPal considers this one of its risk factors in its corporate filings.)

"It can be a contagion," said Lawrence Kaplan, a partner at Paul Hastings. "If you're already working with a bank, you're effectively being regulated by a bank. In that case, are you ready to be a bank?"

Fintech companies would need a clear strategic plan in place and the proper investment in place for regulators to feel comfortable. Those expectations might be even higher if the fintech sought to buy a troubled bank, Ryan said.

"The advantage [with an existing bank] is you could complete the investment sooner, it would probably be quicker to take over the bank," Ryan said. "But you would still have to go through a rigorous application process and undergo regulatory scrutiny."

As a bank, a fintech company would still need to ensure it stays consistent with the bank mission of serving its community, said Craig Focardi, an analyst with the Arlington, Va.-based consulting firm CEB.

"Another thing [for fintechs] to consider, is that community banks are typically focused on one region," he added. "But it is a viable strategy that they could make work."

One notable example of such a success is CBW Bank of Weir, Kan. It was purchased by Google veteran Suresh Ramamurthi and his wife in 2009, and since has been turned around into a font of innovative technology while still being the local bank.

Ramamurthi has said despite the success CBW now has, it had to endure a long period of regulatory scrutiny. When he acquired the bank, it was under distress and had been operating under a cease-and-desist order from the FDIC for nearly two years. It took less than a year to get the order lifted.

The bank also has to routinely undergo regulatory review for different new projects and services it sets out to create.

Such regulatory scrutiny is undoubtedly a hurdle for any fintech company looking to take over a bank, especially a troubled one, said Focardi.

"I think there are some advantages as well as disadvantages," he added.

One sector in fintech that may soon be forced to look at the option of obtaining a bank charter is marketplace lenders, said Christopher DeCresce, an attorney with Covington & Burling.

"They have to register in every state they want to do business in, and that can be a cumbersome process," he said. "A lender that is trying to make loans nationwide may find themselves having a hard time keeping up with the regulatory requirements of each state. A national charter may be more appealing to them."

DeCresce said if an online lender did decide to go the route of acquiring an existing bank, it would have to be of a certain size — at least $500 million in total assets — to effectively launch a national lending platform. While taking over a troubled bank may not be a blanket solution, DeCresce said it could prove successful taken on a case-by-case basis.

"Regulators are still on a bit of a learning curve when it comes to financial technology companies, there's an educational process," he said. "But [the regulators] are already thinking about it, and if it is a case where regulators are presented with something that is a unique solution and gives the market what it wants and at the same time is solving problems for a troubled financial institution, they may be open to it."

Indeed, Fidor's Kroner believes the U.S. regulatory system isn't that far from that of many European countries, and that the U.S. will start to look at giving fintech companies a bank charter.

"I do not think that regulators in other countries are generally more open to a bank charter," for fintechs, he said, noting that in Germany there are currently no more than five open applications. He noted the one exception is the U.K., which Kroner said has upwards of thirty fintech companies applying for a charter, but he says that might not be a good thing.

"Did we ever think about whether this development is sustainable?" he said.

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